How to control hedge funds

The head of the FSA tells Stephen Fay that only concerted international regulation can rein in the Masters of the Universe

HOWARD DAVIES encourages his staff at the Financial Services Authority to think about disaster. A section is dedicated to producing scenarios of financial crisis, but even the most fertile futurologist would have been hard put to forecast that Russia's financial collapse would lead to a dramatic rediscovery of risk. Or that this would wreak such havoc among the hedge funds.

Mr Davies has flown to Sydney for a meeting of regulators from the world's financial markets, which begins tomorrow. Jostling for top place on the agenda is what to do about those vigorous engines for swelling personal wealth, which have had such a destabilising effect recently.

The reason why the hedge funds are now crucial became clear to me 10 days ago in New York, when I sat in front of a screen in a small hedge fund with a dealer friend. I watched mesmerised as the yen went haywire.

The yen gained 6.7 per cent against the US dollar that day. In the jargon, that was 11 standard deviation points, and my dealer friend quickly calculated that the odds against that happening are more than 10 million to one.

He explained that hedge fund managers had become utterly convinced that the yen only lost value against the dollar. Consequently, they were strong sellers. They had taken up huge short positions, and failed to take precautions against a move up. The simple reason the yen had gone mad in a way that was profoundly unhelpful to the Japanese recovery was a symptom of a new order in global finance. The powerful hedge funds had never bothered to hedge.

But prudence was never part of the vocabulary of most hedge funds, which were invented to make large returns on speculative investments. They are on Mr Davies' mind at the Sydney summit of regulators because of some spectacular losses. Consider:

George Soros, the Master of the Universe, lost $2bn (pounds 1.2bn) in Russia.

Tiger Management, run by Julian Robertson, a minor master, lost $2bn in a day when it was on the wrong side of the yen.

DE Shaw, the brainchild of a brilliant professor, borrowed $1.4bn from Bank of America, which confessed last week that it had feared losing the lot.

Everest Capital lost $1.3bn; mortgage bond specialists Ellington lost $1.5bn on bonds last week.

And the biggest loser of all is Long Term Capital Management (LTCM), whose capital was worth $4.8bn and is now worth $1.3bn - or nothing at all, as the case may be. You take your pick.

It certainly puts Nick Leeson's losses into perspective. And these are the cases we know about. Plenty of other hedge funds are keeping mum until they are obliged to report at the end of this year.

It sounds odd, but when Mr Davies flew to Sydney he was fairly confident that the regulators would take no immediate action to curb and control the hedge funds: "Proactive regulators can affect markets, but largely to make them worse," he says.

None the less, he is certain that the only way the funds can be regulated is by formal international agreements of a kind that do not exist. "The main lesson so far is that people are going to be extremely sceptical of having either lending exposure or having massive trades with institutions that aren't prepared to tell them anything about their balance sheet," says Mr Davies.

He must be right about that, right now. But banks and securities businesses like Barclays, UBS and Merrill Lynch had jumped on LTCM's careering bandwagon because they found the promise of quick, above-average returns irresistible. When we spoke last week, just before he flew off, I asked Mr Davies what had happened to human nature to persuade him that such recklessness will not recur when autumn 1998 is a fading memory.

"I can't be sure it won't happen again," he replied. "That's why we're exploring various regulatory responses about the treatment of exposure to hedge funds, and the disclosure requirements that should be expected of them by financial institutions and regulators."

Part of the problem is that hedge funds often started life to care for the fortune of an individual and his family. If the fund was successful, it grew by word of mouth in an atmosphere that encouraged secrecy. Regulators have always found them opaque, but the respectable banks and brokers that lent them such vast sums knew only a little more. This will be basis of the first move by Mr Davies and his colleagues: "If banks and securities houses are lending into a black hole, then we'll have to consider treating that separately.

This financial crisis is the FSA's first real test. Mr Davies and his colleagues have moved into temporary offices in Canary Wharf, but the style is already established. His desk is in an open-plan space, opposite Michael Foot, the chief bank regulator. Passing employees can interpret the expression on the boss's face as they walk by. This is transparency.

The organisation of crisis management is in place, with the Standing Committee on Financial Stability at the top of the pile. The committee's ostensible membership is Mr Davies himself, the Governor of the Bank and the Chancellor, but the real work is done by their shadows - Michael Foot, Steve Robson from the Treasury and David Clementi, the Deputy Governor of the Bank. They study the scenarios.

When specific action is required - when, for example, Barclays reveals a pounds 250m write-off in Russia and follows this up with a boob in LTCM - the job passes to the FSA's Complex Products Group, which supervises the 55 largest organisations in the UK markets, from NatWest to Goldman Sachs to the Halifax. This group is headed by Oliver Page, who came from the Bank, and draws together people who worked for the Bank and specialist regulators like the SIB and the SFA.

On issues like LTCM regulatory contact with colleagues in the US is "instantaneous", says Mr Davies. It was not always so, but he believes that hedge funds can only be regulated internationally. If standards are not uniform in all major markets, the funds will do business where regulation is least robust. This is regulatory arbitrage.

A Russian hunter at the Medved bear-hunting lodge in Siberia
Save the tigerWildlife charities turn to those who kill animals to help save them
Davis says: 'My career has been about filling a niche - there were fewer short actors and fewer roles – but now I'm being offered all kinds of things'
PeopleWarwick Davis on Ricky Gervais, Harry Potter and his perfect role
Frank Lampard will pass Billy Wright and equal Bobby Charton’s caps tally of 106 caps against
sportFormer Chelsea midfielder in Etihad stopgap before New York contract
Arts and Entertainment
The first film introduced Daniel Radcliffe to our screens, pictured here as he prepares to board the train to Hogwarts for the first time.
booksHow reading Harry Potter helps children grow up to be gay-friendly
Arts and Entertainment
A scene from Aladdin is performed at the Tony Awards in New York in June
theatreBrit producer Lythgoe makes kids' musical comedy a Los Angeles hit
Usain Bolt of Jamaica smiles and shakes hands with a competitor after Jamaica won their first heat in the men's 4x100m relay
Chancellor George Osborne, along with the Prime Minister, have been 'complacently claiming the economy is now fixed', according to shadow Chancellor Ed Balls
i100... which is awkward, because he is their boss, after all
Life and Style
A small bag of the drug Ecstasy
Life and Style
Floral-print swim shorts, £26, by Topman,; sunglasses, £215, by Paul Smith,
FashionBag yourself the perfect pair
ebookA unique anthology of reporting and analysis of a crucial period of history
Netherlands' goalkeeper Tim Krul fails to make a save from Costa Rica's midfielder Celso Borges during a penalty shoot-out in the quarter-final between Netherlands and Costa Rica during the 2014 FIFA World Cup
newsGoalkeepers suffer from 'gambler’s fallacy' during shoot-outs
Arts and Entertainment
Standing the test of time: Michael J Fox and Christopher Lloyd in 'Back to the Future'
filmReview: A week late, Secret Cinema arrives as interactive screening goes Back to the Future
Latest stories from i100
Have you tried new the Independent Digital Edition apps?
Independent Dating

By clicking 'Search' you
are agreeing to our
Terms of Use.

iJobs Job Widget
iJobs Money & Business

Financial Analyst - Forecasting - Yorkshire

£300 - £350 per day: Orgtel: Financial Analyst, Forecasting, Halifax, Banking,...

Business Architect - Bristol - £500 per day

£500 per day: Orgtel: Business Architect - Banking - Bristol - £500 per day A...

Regulatory Reporting-MI-Bank-Cardiff-£300/day

£200 - £500 per day + competitive: Orgtel: I am currently working on a large p...

Trainee Recruitment Consultant - Birmingham - Real Staffing

£18000 - £23000 per annum + Commission: SThree: Real Staffing are currently lo...

Day In a Page

Save the Tiger: Meet the hunters tasked with protecting Russia's rare Amur tiger

Hunters protect Russia's rare Amur tiger

In an unusual move, wildlife charities have enlisted those who kill animals to help save them. Oliver Poole travels to Siberia to investigate
Transfers: How has your club fared in summer sales?

How has your club fared in summer sales?

Who have bagged the bargain buys and who have landed the giant turkeys
Warwick Davis: The British actor on Ricky Gervais, how the Harry Potter set became his office, and why he'd like to play a spy

'I'm a realist; I know how hard this business is'

Warwick Davis on Ricky Gervais, Harry Potter and his perfect role
The best swim shorts for men: Bag yourself the perfect pair and make a splash this summer

The best swim shorts for men

Bag yourself the perfect pair and make a splash this summer
Has Ukip’s Glastonbury branch really been possessed by the devil?

Has Ukip’s Glastonbury branch really been possessed by the devil?

Meet the couple blamed for bringing Lucifer into local politics
Dress the Gaza situation up all you like, but the truth hurts

Robert Fisk on Gaza conflict

Dress the situation up all you like, but the truth hurts
Save the tiger: Tiger, tiger burning less brightly as numbers plummet

Tiger, tiger burning less brightly

When William Blake wrote his famous poem there were probably more than 100,000 tigers in the wild. These days they probably number around 3,200
5 News's Andy Bell retraces his grandfather's steps on the First World War battlefields

In grandfather's footsteps

5 News's political editor Andy Bell only knows his grandfather from the compelling diary he kept during WWI. But when he returned to the killing fields where Edwin Vaughan suffered so much, his ancestor came to life
Lifestyle guru Martha Stewart reveals she has flying robot ... to take photos of her farm

Martha Stewart has flying robot

The lifestyle guru used the drone to get a bird's eye view her 153-acre farm in Bedford, New York
Former Labour minister Meg Hillier has demanded 'pootling lanes' for women cyclists

Do women cyclists need 'pootling lanes'?

Simon Usborne (who's more of a hurtler) explains why winning the space race is key to happy riding
A tale of two presidents: George W Bush downs his paintbrush to pen father’s life story

A tale of two presidents

George W Bush downs his paintbrush to pen father’s life story
Restaurateur Mitch Tonks has given the Great Western Pullman dining car a makeover

The dining car makes a comeback

Restaurateur Mitch Tonks has given the Great Western Pullman dining car a makeover
Gallery rage: How are institutions tackling the discomfort of overcrowding this summer?

Gallery rage

How are institutions tackling the discomfort of overcrowding this summer?
Louis van Gaal has £500,000 video surveillance system installed to monitor Manchester United players

Eye on the prize

Louis van Gaal has £500,000 video surveillance system installed to monitor Manchester United players
Women's rugby: Tamara Taylor adds fuel to the ire in quest to land World Cup

Women's rugby

Tamara Taylor adds fuel to the ire in quest to land World Cup